Explaining Covered Calls

Mon, Dec 26, 2011

Investment

Make more from your investments by trading covered calls
If you’re getting started in option trading, covered calls are usually one of the first new strategies you’ll encounter. They’re also popular with experienced traders looking to earn extra income from their portfolios. Writing covered calls is thought one of the lowest-risk strategies for option trading, and can be used in IRAs and non-margin accounts. Five different levels of options trading exist, based on account value and experience with trading. Covered call writing is a first-level strategy, so anyone with a brokerage account can be approved for it.


Identification

A call option is a contract that gives the holder the right to buy the underlying stock at a specific price for a set period of time. The trader who sells the call must be able to deliver the stock if the option holder exercises the contract. A covered call trade involves buying the stock and selling call options against the shares purchased. The purpose of a covered call trade is to collect the option premium as income and possibly make a small capital gain on the stock.

Function
An example can illustrate how a covered call trade works. Let’s say Coca-Cola stock is trading for $53.66 per share. The call option with a $55 strike price that expires in two months is trading for $1.80. The covered call trader enters a trade to buy 100 shares of Coca-Cola and simultaneously sell one call option contract. The cost of the trade is $5,366 for the stock, and the trader receives $180 for the option contract for a net cost of $5,186 plus commissions. If Coke is below the $55 strike when the option expires, the trader keeps the $180 and can write another call option against the stock. If the stock value is above $55, the option will be exercised, the stock will be called away, and the trader will receive $5,500.

Potential
Potential covered call returns are calculated for two possibilities: if the stock remains unchanged, and if the option is exercised and the stock called away. In our example, the result if unchanged is the option premium received divided into the total cost, or 3.4 percent for the two-month period. If the Coke stock, increases the total return will include the gain on the stock from $53.66 to $55. In this example, the return if called is 6.05 percent. The covered call trader wants to repeat this trade four to six times per year, earning 20 percent or better on the invested capital with relatively low risk.

Considerations
Covered call writing works best in a flat to slowly rising market. The profit potential of each trade is limited to the return if called, and the downside is very large if the stock declines significantly. Selecting covered call candidates involves finding stocks with good short-term prospects and near-term call option values that make the trade worthwhile. The covered call trader should have several stocks under consideration so that he can pick the one with the most potential when it is time to trade. Covered call traders must be ready to quickly unwind a trade where the stock starts to fall. One bad trade can wipe out the gains of several winning covered call positions.

Additional Tips
Brokerage commissions can have a significant effect on the final return of covered call trades. Option trades are usually a flat rate plus a fee per contract. The effect of commission can be reduced by using a broker who specializes in options trading and offers lower rates. Also, trading lots of 300 shares plus 3 option contracts or more reduces the effects of commissions. Your brokerage order screen will allow you to enter covered call trades as a net cost. Use this feature plus a limit price to squeeze the bid/ask spreads for a better net cost to enter the trade. The implied volatility of near-the-money call options is a rough estimate of the expected annual return of writing covered calls on the underlying stock. Higher volatility offers higher returns and a higher risk of loss.

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